Lesson 2 of 7 · 13 min

Risk aversion and utility

A utility function turns each investor's attitude to risk into one number per investment, so investments can be ranked: U=E(r)−12Aσ2U = E(r) - \tfrac{1}{2}A\sigma^2.

In short

  • Offered a sure amount or a gamble with the same expected value: the risk-averse investor takes the sure amount, the risk-neutral investor is indifferent, the risk seeker takes the gamble.
  • Markets price assets as if the typical investor is risk averse; we assume risk aversion from here on.
  • Risk tolerance is the opposite of risk aversion: more tolerance, more willingness to take risk.
  • Utility U=E(r)−12Aσ2U = E(r) - \tfrac{1}{2}A\sigma^2: A>0A > 0 risk averse, A=0A = 0 risk neutral, A<0A < 0 risk seeking.
  • Utility only ranks choices for one investor; it cannot be compared or added across people.
  • A risk-free asset (σ=0\sigma = 0) gives the same utility to everyone: its return.

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Risk aversion and utility · Portfolio Risk and Return: Part I